A prominent banking regulator yesterday warned that derivatives market participants must implement risk management practices more aggressively, or regulators will do the job for them.
David Mullins, vice chairman of the Federal Reserve System's Board of Governors, yesterday endorsed many of the risk management recommendations issued last week by the Group of Thirty.
The group's 20, recommendations, contained in a report written by derivatives dealers and users range from urging better disclosure of derivatives portfolios to promoting the use of independent risk evaluators within firms.
If such practices go unadopted, regulators will probably craft their own rules for the industry, Mullins told attendees at a conference in New York City sponsored by the International Swaps and Derivatives Association.
"If the industry does not assume (he responsibility for addressing public policy concerns and do this job well, others are quite willing to take discretion out of the industry's hands and do the job perhaps much less well," Mullins said. "Regulatory micromanagement would be particularly counterproductive in this innovative marketplace."
The findings on industry practice contained in the Group of Thirty study demonstrate the need for additional measures, Mullins said.
"The recommendations are anything but a sanctification of the status quo," Mullins told the gathering of derivatives professionals. The survey found that "most end-users and many dealers do not follow all, or in some cases many, of the report's recommendations."
Mullins was somewhat critical of the study's conclusion that derivatives are no riskier than standard financial products.
The study indicates that using derivatives presents the same risks as using other, simpler financial products.
For example, if interest rates rise, a bank could find that an interest rate swap that was once profitable has become unprofitable. But this so-called market risk is also present in simple, fixed-rate bonds: The value of the bonds will fall as rates rise, although probably not by as much as the value of derivatives would.
While agreeing that derivatives do not present new risks, Mullins warned that "the complexity and diversity of derivatives activities make the measurement and control of risks more difficult and more important than is the case with traditional instruments."
Mullins did say that he felt it was "important not to overstate the systematic risk potential of derivatives."
The authors of the Group of Thirty study welcomed Mullins' remarks. "We're pleased that David Mullins addressed this group," said Patrick de Saint-Aignan, a cochairman of the Group of Thirty's working group on the study and a managing director at Morgan Stanley & Co." And we are pleased to see implementation is already taking place."
Dennis Weatherstone, chairman of the Group of Thirty report's steering commitee and the chairman of J.P. Morgan & Co., told attendees at yesterday's conference that his firm had already initiated a complete review of its risk management practices.
In a memo sent out to derivatives managers last week, officials at J.P. Morgan asked the managers to list how the firm's practices differed from the study's recommendations.
"This should specify where we fully meet the recommendations, where we meet them but could do more, and where we fall short. For the latter, indicate where we need to change and if not, why," the memo says.